I’ve been thinking…Just what is the M&A Process in an LBO deal?
This blog is a follow on to a companion blog, A Deep Dive into the Auction Process of LBOs, which explored the typical actions of both the target that put itself up for sale through an auction process and the buyout firms who participated in that auction. In contrast, this blog’s focus is on the M&A process in an LBO deal, which includes not only the target’s selection process of the auction winner but also the negotiation process between the auction winner and the target regarding the terms and conditions of the definitive acquisition agreement. This blog also deals with (i) the winning buyout firm’s finalization of the contemplated debt financing supplied by the lenders and debt investors, (ii) financial engineering in the LBO capital structure, and (iii) the typical actions the buyout firm takes (as the new owner) immediately after the LBO deal closes.
Selecting the Winning Bidder and Negotiating the Acquisition Agreement
Once the LBO advisor receives the final offers from those buyout firms willing to go forward with the transaction, those offers are shared with the target’s board and executives. A decision process must be established in which the target decides which buyout firm is most likely to close the deal, assuming the offer is acceptable to the target. In my experience, this decision requires that all of the acceptable final offers be individually analyzed, compared and ranked. This is a fact specific exercise, requiring a comparative evaluation of, among other things, the different prices offered, the sets of accompanying terms and conditions, the arrangements of the unique debt financing proposals of each offer and any requests for additional time to complete outstanding due diligence items, including outstanding legal matters. Often there is room for counter offers.
In the end, only one buyout firm is selected to enter into exclusive negotiations with the target regarding the terms and conditions of the definitive acquisition agreement. In the negotiations, each party is represented by their own team of legal advisors. Often, representatives of the LBO firm’s investment committee join the deal team in concluding the negotiations. The time required to reach agreement is fact specific, but the end result is the so-called merger agreement, which will guide the M&A process through the agreed upon closing date of the LBO deal.
After the merger agreement is signed, and until the LBO closes, the target is still owned by the target’s existing shareholders. It is fact specific as to whether the target’s shareholders must vote to approve the merger agreement. In any case, the target’s executives work closely with the winning buyout firm to effect a timely closing, including ensuring the debt portions of the LBO are successfully funded on the timely basis.
The Decision to Submit a Final Bid
The decision to submit a final bid is invariably backed up by the final draft of the investment memo, which is authored by the deal team and discussed thoroughly at the investment committee level. Already familiar with the material details of the LBO deal from earlier investment memo drafts, the investment committee’s attention is focused on the final iteration of the LBO model and, among other things, the reasonableness of the projections that support the proposed offer. In my experience, the investment committee approval process of buyout firms can vary between requiring a simple majority of committee members to unanimity.
Private equity firms owe a fiduciary duty to the investors in their associated private equity funds. This means that the investment committee must be reasonably convinced that the buyer due diligence investigation performed on the deal was reasonable and met the standard of care and custom and practice required of fiduciaries.
Standard of Care and Custom and Practice in Buyer Due Diligence
Standard of Care: The applicable standard of care in buyer due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of material information relied on by the buyer. The reasonableness standard is that applied by the prudent person in the management of his/her affairs. The materiality standard is that information is required to be reasonably investigated if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.
Custom and Practice: The custom and practice in performing a reasonable due diligence investigation is as follows: (1) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate); (2) to follow up and reasonably understand and resolve material red flags (that is, information encountered in the course of a due diligence investigation that is inconsistent with the buyer’s understanding of the target’s businesses, executives, operations, accounting or finances or that is potentially indicative of wrongdoing and, therefore, requires the buyer to investigate further in order to arrive at a reasonably informed understanding or resolution) and to investigate and reasonably resolve issues encountered during due diligence that may not rise to the level of red flags but which warrant reasonable investigation under the circumstances; if the results of the follow up investigation are not satisfactory to the buyer, the alternatives faced are either withdrawing from the transaction or accepting the risks of not conducting due diligence with reasonable care; and (3) to independently verify material information supplied by executives and advisors of the target (or other parties with potential conflicts of interest) on which the buyer intends to rely.
The Due Diligence Supporting the Winning Bid
Support for the buyout firm’s final offer is contained in the final investment memo, which is largely based on the buyer due diligence performed on the LBO deal. In my experience, the LBO financial model plays an outsized role in the decision to make a final offer. The LBO financial model starts with key input assumptions for, among other things, the entry purchase multiple and price, relevant underwriting standards and minimum credit metrics from both lenders and debt investors, the debt funding mix and the equity-debt split. These assumptions help form the backbone of the initial output of the financial model, which in part includes detailed projections of EBITDA and free cash flow, debt repayments, capital expenditures (capex), source and use of funds, estimated deal expenses, exit multiple range, IRR calculations and sensitivity analyses.
Not every target is a good candidate for a successful LBO transaction. In my experience, a successful LBO has a reasonable balance of both (i) financial engineering in the capital structure, including the mix of equity securities and various types of debt, and (ii) operating improvements, which refers to, among other things, projected improvements to cash flows that are deemed reasonable in part because of the results of the buyout firm’s due diligence investigation as well as its domain knowledge and experience in the target’s business. While the benefits of the financial engineering techniques are built into the final offer, the projected benefits of the identified operating improvements can only be fully realized after the LBO closes and the buyout firm is in complete control.
Buyout firms pay particular attention to the complicated interactions of key outputs of the financial model, including the amount of equity required. For example, not only is the sufficiency of the amounts and timing of free cash flows and EBITDA closely scrutinized, but also the nature, amounts and timing of debt being sought from outside lenders and debt investors are analyzed for internal consistency with the creditors’ reasonably expected underwriting standards and minimum credit metrics. In addition, the revenue and expense projections must be feasible and able to reasonably generate sufficient cash flows to satisfy the estimated financial and non-financial constraints that the individual creditors will insist upon when negotiating the debt portions of the deal. Finally, the projected IRR from the financial model must be sufficient to justify the risks of moving forward with the LBO deal.
The Winning Bidder Negotiates the Debt Components of the LBO Deal
While the details are fact specific, the deal team had already predicated its final offer on a specific level of financial engineering in the capital structure, including the mix of equity securities and various types, amounts and costs of debt. In my experience, the typical LBO deal projects not only a set amount of senior debt supplied by a group of lenders but also a set amount of a so-called revolver loan, which is funded by the same lenders. In addition, the typical LBO taps the debt capital markets for a set amount of subordinated debt (high yield debt or junk bonds) and often a set amount of so-called mezzanine securities. While fact specific, the deal team typically relies on its financial advisor’s so-called capital markets group to sign off on the reasonableness of the estimates used in the debt components of the LBO financial model.
After the terms and conditions of the merger agreement have been negotiated, but before the scheduled closing date, the funding of the LBO debt must be finalized not only with the selected lenders but also with the targeted debt investors. Any material differences from the amounts and costs estimated in the final LBO financial model will change the final IRR calculation and/or the final debt-equity funding mix.
Not surprisingly, lenders not only demand up-to-date data on both the target’s recent financial and operating performance and its projections, but lenders also want a clear demonstration that such data meet the lenders’ credit underwriting standards and minimum credit metrics for the nature of the lending commitments sought. In my experience, the deal team and its financial advisors help the target’s financial executives prepare the required financial and operating submissions to the lenders and participate in any direct follow up and/or Q&A by the lenders.
It is customary that the borrower in the case of loans, or the issuer in the case of debt securities, is a newly-formed firm owned and controlled by the buyout firm and/or its affiliates, which will be merged into the target at the time of closing.
Debt investors require a different approach from lenders because the sale of debt securities must comply with applicable securities laws. It is customary for the deal team to engage its financial advisor in an underwriter capacity and to prepare offering documents to solicit potential debt investors on behalf of the issuer. If the LBO debt financing will use both subordinated debt and mezzanine securities, then depending on the specific facts, separate offering documents from the issuer may be required.
The preparation and distribution of securities offering documents is exacting and time-consuming work that carries with it due diligence responsibilities for both the issuer and the underwriter. The individual due diligence investigations of the issuer and underwriter serve as the reasonable bases for both parties to believe that material information disclosed in the offering documents is accurate and complete in all material respects. It is customary that potential debt investors are invited to attend a so-called roadshow covering, among other things, the LBO transaction, the issuer and the debt securities being offered.
It is fact specific just how much of a role the target’s existing executives will play in the company post-closing operations. Often, key executives of the target are singled out and offered significant roles after the close, including rolling over of their existing equity ownership in the target and participation in other financial incentives tied to the successful performance of the post-LBO company.
Financial Engineering in the LBO Capital Structure
In my experience, a key goal of an LBO is to maximize the IRR on exit. One key strategy consists of financial engineering in the capital structure, not only in the debt portion but also in the equity portion. The other key strategy is operating improvements, which is discussed in the next section and refers to projected improvements to cash flows implemented by the buyout firm after closing.
Financial engineering of the debt portion of the capital structure involves layering in the maximum amounts of low-cost senior debt (and revolver debt) with the maximum amount of higher cost subordinated debt. If applicable, mezzanine debt is added. The balance of each type of debt must be consistent with applicable debt capital market underwriting standards and minimum credit metrics.
While a reasonable amount of leverage can be used to improve the IRR of a deal financed by 100% equity, creditors have their own ideas of what is reasonable leverage. For example, lenders have minimum underwriter standards, including minimum credit metrics, regarding such ratio measures as (i) leverage ratio (debt/EBITDA), (ii) interest coverage ratio (EBIT/interest), (iii) debt service coverage ratio (EBITDA – capex)/(interest + principal), and (iv) fixed charge coverage ratio (EBITDA – capex – taxes)/(interest + principal).
Financial engineering of the equity portion of the capital structure involves designing a limited array of equity securities with different rights and issuing those securities with preferred rights to the buyout funds that will own the target post closing. An example of such a preferred security is one with cumulative dividend rights. On exit, investors owning equity securities with cumulative dividend rights have preference to the exit proceeds over other investors owning non-preference equity securities.
Typical Actions of New Owners After the Closing Date
For the closing to occur, a number of customary actions must take place simultaneously, including in part the following: (1) distributing cash in accordance with the agreed upon cash distribution schedule, including paying the agreed upon offer price to the target’s shareholders by drawing funds from (a) identified lenders and debt investors (in return for the associated loans and debt securities in the new firm), and (b) identified buyout funds (in return for the associated equity shares in the new firm); (2) attending to administrative matters, such as the completion of the reverse merger and any required name changes or share trading symbol changes; and (3) attending to corporate governance matters, such as holding the required organization board meeting, adopting the agreed upon Articles and By-laws, electing new board members to assure control by the new owners, adopting new incentive compensation plans, and approving the board’s new meeting schedule and agenda format.
Implementing Operating Improvements After the Close
Once the buyout is completed, the buyout firm’s executives set about to timely orchestrate a set of value-added operating improvements, which were identified in the final investment memo. More particularly, such operating improvements are based on projected improvements to cash flows that are deemed reasonable in part because of the results of the buyout firm’s due diligence investigation as well as its domain knowledge and experience in the target’s business.
In my experience, as the new owner, the buyout firm seeks to realize the identified operating improvements by, among other things, controlling the company’s board membership and working through a new or existing team of company executives who are financially motivated to timely achieve the value-added changes. By continuously monitoring progress against plan on the value drivers of the company, the board will have the opportunity to decide on a timely exit transaction, which maximizes the LBO transaction’s internal rate of return.
Final Notes on the Buyout Business
The 5-7 year life of the typical buyout fund reflects the belief that a portfolio of LBO investments can be sourced, diligenced, negotiated, closed, restructured/repositioned, and successfully exited within the life of the limited partnership. In addition, the buyout business model charges its portfolio companies (i) a monthly management fee, (ii) a deal origination fee for arranging the buyout, and (iii) financing fees on future fundraising by the company. It is customary for these fees, which are paid to the buyout firm, to offset the management fees charged by the buyout firm to the buyout fund.